January 22, 2010

Proprietary traders are an obvious target for Obama’s reforms

President Barack Obama’s clampdown on proprietary trading may have caught the market by surprise, but it was an obvious target for reform.

Proprietary trading is the rather grand name given to the use of banks’ own money to take positions in the market. Bankers like Michael Geoghegan, the boss of HSBC, may complain that it is “fashionable” to bash bankers, but hats off to anyone who can come up with a convincing case for banks to run big proprietary trading desks.

The problem with proprietary trading, as far as I am concerned, is not that it’s risky. Banking is all about taking calculated risks. If banks didn’t take any risk, they wouldn’t lend anyone any money. So preventing risk-taking should not be the objective of financial reform

But the nature of proprietary trading is that banks wager their own money by taking big positions, often in complex financial instruments. They do so because, when they get it right, it is an easy way of making money, which doesn’t require relationships with pesky clients, bull market conditions or any other uncontrollable variables. By the same token, no one gets it right all the time, and when proprietary traders get it wrong, things can get very ugly.

Proponents will argue that the risks involved, though high, are perfectly manageable in a well-run bank. This may be true – though I can’t think of a bank involved in proprietary trading which hasn’t taken a big hit at one time or another, and whenever a “rogue” trader strikes, he nearly always turns out to have been sitting on the proprietary trading desk. In any case, well-run institutions have turned out to be a lot thinner on the ground than we once thought.

The real problem, though, is that such activities are, it turns out, underwritten by the taxpayer and there is an economic justification for bailing out banks, only if they are vital to the smooth running of the financial system.

But taxpayers are not the only ones with reason to worry about proprietary trading. Bank shareholders aren’t too happy about it either (and banks believed to rely excessively on proprietary trading are less highly valued as a result). What particularly annoys shareholders is that they cannot even tell how reliant a particular bank is on such revenues. Goldman Sachs, where folk may not be feeling particularly chipper despite predictably bumper earnings on Thursday, says that it makes around 10pc of its revenues from proprietary trading, but there is no regulatory or accounting requirement for such disclosure.

Many banks run discrete proprietary trading desks, but it is famously easy to bury revenues in other activities: one executive arrived at a newly acquired bank to discover that its treasury operation – which in theory serves companies’ short-term financing needs – was in fact a giant proprietary trading desk.

Lastly, the banks’ own clients are not fans of proprietary trading either, because they suspect that traders bet against them. In theory, there are dividing lines between client-facing and proprietary businesses, but no one believes these work properly. And because big banks have such huge flows of business, it is impossible to tell which trades are for clients and which are on their own account. Several successful proprietary traders have noticed that their jobs suddenly became much harder when they set up as hedge fund managers and prices begin to move inopportunely against them.

Even without action by President Obama, proprietary trading was set to decline as stricter capital requirements hit riskier activities. But the Obama plan is much more radical. There are two big dangers. If the rules are too tough, they could make it difficult for banks to conduct market-making activities, which would result in higher costs for their clients (though arguably these costs would at least be transparent). If too weak, the rules will be ineffective, because proprietary profits will simply be transferred to other desks.

Paul Volcker, the former Federal Reserve chairman and adviser to President Obama who has pushed for this move, believes that “the distinction between ‘proprietary’ and ‘customer-related’ may be cloudy at the border. But surely by the active use of capital requirements and the exercise of supervisory authority, appropriate restraint can be maintained.” I hope he is right.

Meanwhile, talented traders will still be able to take huge risks with their own institution’s funds – provided they work for hedge funds. Most of these are privately-held partnerships, serving sophisticated investors. More importantly, they are not underpinned by the state.

The much-maligned hedge fund is, in fact, the appropriate vehicle for this sort of risk-taking.

The primary aim in regulatory policy should be to make it possible for banks to fail without endangering the rest of the banking system – and society. The proposed remedy, however, does not help with this. Even financial networks where companies each did only one thing would still be vulnerable to systemic crises.

Boundaries between bank functions will be hard to draw. Will affected banks be allowed to hedge their positions? This brutal regulation will be set upon by lawyers.

Banning prop trading by retail banks would prevent state-insured deposits being used as chips in the financial casino. This problem is, however, best tackled by charging banks appropriately for risks that the state insures them against.

The government’s key policy lever should be to make sure that institutions hold enough capital to reflect the risks that they run and the threats that they pose to the rest of the financial system

Obama and US banks

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// ]]>Simple question: how will President Obama’s proposals affect US banks? Unfortunate answer: no one yet knows. The new scheme – which covers a ban on proprietary trading, a ban on ownership, investment in or sponsorship of hedge funds and private equity, and new limits on the overall size of banks – is vague and will doubtless change before it becomes a reality.

The detail will make a huge difference. For example, pure proprietary trading – investment by the bank on its own, not clients’ behalf – at JPMorgan Chase contributes well below 1 per cent of revenues. But much client trading involves taking balance sheet positions and then holding them. So when does client work cross the line into prop trading? Determining what constitutes “sponsorship” of a hedge fund will also be crucial. Asset management vehicles that take short positions (and in which some banks invest alongside clients) could be affected. But lending and advisory services, such as prime brokerage and leveraged finance, seemingly will not be.

The bottom line is that banks will have to choose between owning a deposit-taking institution, with access to emergency federal funding, and supposedly higher-risk activities. That suggests that Goldman Sachs and Morgan Stanley could relinquish bank status, avoiding major changes to their businesses and challenging regulators to keep tabs on them outside the bank system. The proposals, then, could be more arduous for the largest, integrated banks, such as JPMorgan and Bank of America, which could also face limits on their growth from a new cap on bank size.

This is not a return to Glass-Steagall. It is a targeted attack on specific businesses that the government does not wish to back. Yes, those activities can be risky. They will require regulation whether in or outside banks. They were also not the cause of most bank losses.

The detail will make a huge difference. For example, pure proprietary trading – investment by the bank on its own, not clients’ behalf – at JPMorgan Chase contributes well below 1 per cent of revenues. But much client trading involves taking balance sheet positions and then holding them. So when does client work cross the line into prop trading?

Lex is right about something else too:

This is not a return to Glass-Steagall. It is a targeted attack on specific businesses that the government does not wish to back. Yes, those activities can be risky. They will require regulation whether in or outside banks. They were also not the cause of most bank losses.

Exactly.

Suppose Goldman Sachs were to comply with the Volcker rule by relinquishing its bank status (which it adopted after the crisis was upon us, with the authorities’ blessing, to avail itself of the full range of assistance). When the next crisis comes round, would the Treasury be able to let Goldman fail? The Lehman experience answers the question. Lehman was not a commercial bank. If Goldman, having reverted to non-”bank” status, could not be allowed to fail, what would the Volcker rule have achieved? Whether or not Goldman is a bank, it has to be more tightly regulated.

This is mainly a political initiative, as the FT report notes, and not without political risk. One danger is creating and exposing disarray inside the Obama economic team. The new proposal, good or bad, is a U-turn. Geithner has spent months arguing for a different approach. His days must now be numbered. (In Britain, his position would be described as “unassailable”.)

The other risk is Volcker himself. If Obama intends to use him as front-man for populist bank-bashing, I’d bet that before long he will regret it. Volcker is forthright, immensely experienced and widely respected. That is why he is so valuable. But he is also apolitical, fiercely independent, and nobody’s shill. Not the ideal pitch-man.

Goldman would be hit hardest by prop-trading limits

During a conference call with analysts on Thursday, Goldman Chief Financial Officer David Viniar was peppered with questions about the proposal and the potential impact if it becomes law.

Viniar said proprietary trading, in which institutions trade with their own money for their own benefit with no client involvement, accounts for roughly 10% of annual revenue at Goldman.

Goldman generated more than $45 billion in net revenue in 2009, so a ban on prop trading last year could have knocked about $4.5 billion off that total.

Prop trading probably has higher profit margins than some of Goldman’s other businesses, according to Hecht and Matt Albrecht, a financials analyst at Standard & Poor’s Equity Research.

Expenses probably consist of compensation for traders and the cost of the capital used, but there are likely no marketing costs and few other overheads, Albrecht explained.

That means a ban on prop trading could have a bigger impact on Goldman’s profit.

Albrecht also noted that prop trading could account for up to 20% of Goldman’s revenue during a particularly successful quarter. That’s especially true if the firm’s other businesses struggled during the same period.

At banks with larger retail and commercial banking businesses, such at J.P. Morgan, Bank of America and Citi, prop trading is even less important, the analysts added.

Prop trading accounts for less than 5% of annual net revenue at Morgan Stanley and less than 1% at J.P. Morgan, according to people familiar with the situation

“Banks like J.P. Morgan and Citi have more consumer-facing businesses which give them a more diverse revenue base to offset any limits on prop trading.” Albrecht said. “Goldman is he most tied to this, then Morgan and then the large banks.”

However, the analyst said all large banks face regulatory uncertainty.

“New capital rules, limits on derivatives and hedging, taxes on liabilities and compensation. The future is unclear for these firms,” Albrecht added.

Solution?

Glenn Schorr, an analyst at UBS, said Goldman could reduce the impact of prop-trading limits by letting traders set up hedge funds. Those vehicles could then raise money from outside investors and the operation could be moved into Goldman’s asset-management business.

Indeed, Goldman has already launched successful hedge funds in this way. In late 2007, the firm launched Goldman Sachs Investment Partners with at least $6 billion in assets. The fund is run by Raanan Agus and Kenneth Eberts, prop traders who’d been at Goldman for more than a decade each. The hedge fund launch was one of the biggest ever. Read about the launch.

“The pure walled-off proprietary trading businesses at Goldman Sachs are not very big in the context of the firm,” Viniar said. “So if we had to do something with them, we could.”

Hedge fund, private-equity limits

However, Obama’s proposed limits on hedge fund and private-equity businesses at banks could hamper such a solution. These limits would also have a big impact on J.P. Morgan.

J.P. Morgan had the second-largest hedge fund business in the world at the end of June, with $36 billion in assets, according to industry publication AR. Goldman’s hedge fund business was sixth, with almost $21 billion in assets.

A ban on owning, investing in or sponsoring hedge funds would mean these firms miss out on lucrative annual management and performance fees, which often run as high as 2% and 20%.

Goldman’s asset-management business collected $137 million in performance fees last year. In 2008, it collected $231 million. Not all those fees may have come from hedge funds, but performance fees are less common in the traditional asset-management industry.

Goldman also runs a leading private-equity business. Obama’s proposal to ban banks from owning, investing in or sponsoring private-equity funds could have a bigger impact on Goldman than hedge fund limits.

Goldman’s Viniar said Thursday that the firm’s private-equity business is “important” and “very integrated” with the rest of its businesses.

“There are a lot of our very important clients invested in our private equity business,” he said, according to a transcript of Thursday’s conference call with analysts. “We invest alongside other clients of the firm, and we invest in clients to help them grow. So it is very much… an integrated client-oriented business.”

Status change?

If these limits become law, along with new taxes and other restrictions, it raises the question whether Goldman wants to be a financial holding company anymore, Hecht said. The analyst asked Viniar about this during Thursday’s conference call and got an emphatic answer.

“It is not an option at all,” Viniar said. “It is not even — not something we ever even think about or talk about.”

Goldman used to be regulated by the Securities and Exchange Commission as a brokerage firm. However, it became a financial holding company in the midst of the 2008 financial crisis. That change gave it access to emergency loans from the Federal Reserve, but also exposed the firm to tighter Fed regulations.

As one of the largest financial intermediaries and counterparties in the world, Goldman needs to be regulated and also needs solid sources of capital, Hecht explained.

“But the government is in their face,” Hecht added. “There’s no way to hide from that.”

Alistair Barr is a reporter for MarketWatch in San Francisco

Prop trading

While worries of further regulatory change hit bank stocks, analysts agreed proprietary trading — or making bets with the bank’s own money — is a less significant business for European firms with investment banking operations than it is for the likes of Goldman Sachs /quotes/comstock/13*!gs/quotes/nls/gs (GS153.70, -0.42, -0.27%) .

Deutsche Bank, for example, has said proprietary trading contributed just 5% to underlying sales and trading revenue in 2009.

“Furthermore, we doubt shareholders would be overly upset to see the remaining dedicated prop activities exited,” he added.

Clark estimated that removing proprietary trading would reduce earnings per share at European banks by between 1% and 5%, which could be partly offset by the reallocation of capital.

Analysts at UBS estimated proprietary trading contributed less than 5% of group revenue for all the major European banks they cover.

Analysts at Macquarie group came up with a similar figure for most banks and said Barclays is seen as the most exposed U.K. bank, estimating that 9% of its total revenue could be “at risk” from a change to the regulations.

KBW’s Clark said hedge fund and private-equity activity contribute between 3% and 8% of overall profit at European investment banks and are more of a core business than proprietary trading.

But he added that regulators in the likes of Switzerland and Germany are unlikely to follow the U.S. lead in this area because Switzerland has been trying to establish itself as a leading hedge fund center and Germany’s banking system has inherent private equity characteristics.

Options risk gauge surges after Obama`s banking plan

The VIX, a favorite Wall Street gauge of investor anxiety, surged to it highest levels in more than a month on Thursday as US stocks tumbled on Obama administration proposals to stop US banks taking excessive risks.

“Obama’s announcement today from a derivatives perspective has thrown uncertainty into the mix,” said Carl Mason, head of U.S. equity derivatives strategy at BNP Paribas in New York

People don’t know what form those rules will take for the banks. Uncertainty tends to breed volatility and increase expectations of more future volatility,” Mason added.Frederic Ruffy, an options strategist with WhatsTrading.com, said in comments on the website that the news “suggests greater regulatory scrutiny and probably a more difficult operating environment for the nation’s biggest financial institutions.”

The index soared past the key psychological level of 20 Thursday morning, in what could be the start of a push upward.

Many option investors braced for higher volatility and aggressively picked up February VIX call options that expire in just a few weeks as likely insurance against a severe pullback in U.S. equities.

Most of the activity was in the front-month February VIX options with brisk call action in the 20, 22.50, 25, 27.50, 32.50 and 35 strikes.

The trades included a well-timed purchase of 25,000 February out-of-the-money 32.50 VIX calls at 35 cents per contract in morning action, Ruffy said.

In all, 37,870 contracts traded in that strike, Reuters data show.

That’s because there is a blurry line between the two, in part due to the proliferation of algorithmic technology and the practice of banks taking on internal speculative positions, or simply opposite positions, to aid their market-making operations.

As Kemp explains, it will take a lot of nosing aroundwithin institutional practices to determine what’s what. That in itself is likely to be a monster of a job:

MARKET-MAKING FUNCTION The biggest problem will be separately identifying proprietary trading on the banks’ own account from legitimate market-making activities on behalf of customers.

Most banks have separate private equity departments. Some also have dedicated prop trading desks and internal hedge funds. But in many cases prop trading and hedge fund like activities have not been separated out. It will prove hard to identify which securities are being held for strategic “speculation” and which are being held as part of a tactical, liquidity-producing trading book.

In many instances the distinction may not make much sense, and is not how banks organise their operations. Difficulty in implementation is not a reason not to press ahead. Detailed regulations can be drafted later. Enforcing a separation between proprietary trading and market making will require considerable intrusion from regulators (either in the form of rather blunt prohibitions or very intensive supervisory visits and demands for data).

Until now, supervisors have been reluctant to interfere this much in the internal workings of banks. But beefed up regulation is the inevitable condition for taxpayer support, and Obama’s endorsement will stiffen regulators’ resolve in the United States and elsewhere.

The President has shown courage in tackling the banking system and opened the door to changes across the world

How far can the President push the banks? Like many I would have liked to have explicitly seen a new Glass Steagall Act. This was the 1933 legislation, abandoned in 1999, that meant commercial and investment banks had to be separate. It worked: we had nothing like the current crisis whilst we had it. We had crises before it. We’ve had them after it.

We do, however, have to be realistic. Going back to the status quo ante is just not possible sometimes. Obama’s new rule will radically alter the risk profile of banks. The Bank for International Settlements suggests 43% of all foreign exchange trading is on bank’s own account, for example. Almost all of this will now have to be ring-fenced from deposit taking. And hedge funds and private equity are massively volatile. However the risk will not be ring-fenced if the deposit-taking banks simply lend their capital to the risk-taking banks in future, leaving them exposed second hand.

The rules have also to require that those who will be trading, hedging and private-equity dealing do so out of their own capital, and not the capital of deposit-making citizens. Only then will the risk be segregated.

The details will be diabolical work, as ever. But for now Obama deserves applause for at last following his instinct and showing the courage to tackle the biggest crisis of our time: the takeover of our economies and well being, by banks motivated by their own well being. It’s a battle he has to win.

Richard Murphy FCA FRSA is a U.K. chartered accountant, former serial entrepreneur and is currently director of Tax Research U.K. He has been a visiting fellow at several U.K. universities and now works mainly on tax and economic policy issues for a wide range of organizations including the U.K. Trade Union Congress and the Tax Justice Network. He blogs at www.taxresearch.org.uk/blog